TAX AND ESTATE PLANNING FOR PENSION AND IRA ASSETS



TAX AND ESTATE PLANNING FOR PENSION AND IRA ASSETS

Most estate planners have the opportunity to plan for their clients’ retirement assets on a regular basis. This outline is intended to serve as a general guide to estate planners as they work with their clients to complete beneficiary designations for these retirement accounts. This outline does not address how retirement plans and accounts are invested or managed, nor does it address the rules governing contributions to retirement plans and accounts. This outline also does not address lifetime distributions from retirement plans and accounts. Instead, this outline focuses solely on the basic information estate planners should know to be able to assist their clients prepare their retirement plans and accounts for their deaths, in a way that meets the needs of their clients and their clients’ beneficiaries, and that minimizes income taxes to the extent possible.

Types of Retirement Assets

The types of retirement assets discussed in this outline are qualified retirement plans and IRAs. A “qualified retirement plan” is a plan that meets the requirements of §401(a) in the Internal Revenue Code, which includes 401(k) plans, defined benefit plans, profit-sharing plans, money purchase plans, Keogh plans, and employee stock ownership plans. The term “IRA”, as used in this outline, applies to traditional IRAs, SEP-IRAs, SIMPLE IRAs, and Roth IRAs, unless otherwise specified. For convenience, “retirement plan or account” means a qualified retirement plan or IRA. While 403(b) plans are outside the scope of this outline, most of the material in this outline applies to 403(b) plans as well.

Benefits of Deferral and RMDs

The primary benefit of retirement plans and accounts are their tax-favored treatment. In most cases (Roth IRAs are an exception), cash (or other property) is contributed to a retirement plan or account on a pre-tax basis, and the investment income earned on the contribution is not subject to tax for as long as it remains in the retirement plan or account. The longer the assets stay in the retirement plan or account, the greater the benefit to the owner or participant.

Of course, Congress does not allow an IRA owner or a participant in a qualified retirement plan (“owner/participant”) to keep assets in a retirement plan or account indefinitely. Congress, in Section 401(a)(9) of the Internal Revenue Code, has established rules mandating distributions. These distributions are often called required minimum distributions (collectively, “RMDs”, individually, an “RMD”). While Section 401(a)(9) itself is relatively brief, the Treasury Regulations interpreting Section 401(a)(9) are voluminous and contain many traps for even experienced estate planners. However, with careful planning around these regulations, not only can the owner/participant enjoy tax-deferred growth on retirement assets, the owner/participant’s beneficiaries can enjoy such benefits as well.

The Beneficiary Designation Form

In most circumstances, the terms of the owner/participant’s Will or revocable trust have no bearing on how the retirement account or plan benefits are distributed upon death. Instead, retirement assets, like life insurance, pass by contract, without the need for a probate proceeding. A part of this contract is the beneficiary designation form, which is typically completed by the owner/participant when the account was opened or when the participant began participating in the retirement plan. The beneficiary designation form may then be updated by the owner/participant at any time.

Like the name suggests, the beneficiary designation form is the document that the IRA custodian or qualified retirement plan administrator will rely on—almost exclusively—to determine who benefits from the retirement plan or account following the owner/participant’s death. (A plan administrator or IRA custodian will also rely on the terms of the retirement plan’s or account’s governing documents, the custodian’s or administrator’s internal policies, and the Internal Revenue Code and Treasury Regulations but these are outside of the estate planner’s ability to control). To a significant extent, how a beneficiary designation form is completed also affects the extent to which the beneficiary is able to take advantage of tax-deferment following the owner/participant’s death. Therefore, how this form is completed is particularly important. Aside from the account number and biographical information about the owner or participant, most beneficiary designation forms ask only to identify the beneficiaries. This seems simple enough, but, as discussed below, choosing beneficiaries is often far from simple because of the very different consequences that result from naming one type of beneficiary instead of another.

Concepts and Definitions

First, it is important to identify a few terms that are used repeatedly in the Treasury Regulations and this outline, and that are important to understanding the options available to the owner/participant’s beneficiary following the owner/participant’s death.

Designated Beneficiary

According to the Treasury Regulations, a “Designated Beneficiary” is “an individual who is designated as a beneficiary under the plan. . . . A beneficiary designated as such under the plan is an individual who is entitled to a portion of an employee’s benefit, contingent on the employee’s death or another specified event.”[1] To illustrate, if an individual identified on the beneficiary designation form as the primary beneficiary is living at the time of the owner/participant’s death, the primary beneficiary so designated is the Designated Beneficiary, provided that he does not disclaim his interest. Note that in this example, because the primary beneficiary survived the owner/participant and did not disclaim his interest, the contingent beneficiary is irrelevant.

The regulations clarify that the owner/participant need not affirmatively specify an individual beneficiary (such as on a beneficiary designation form) in order for that beneficiary to qualify as a Designated Beneficiary; rather, it is sufficient that the beneficiary is designated under the plan’s governing document.[2] For example, if a participant in a qualified plan did not complete a valid beneficiary designation form, but the plan’s governing instrument provides that in such a case the participant’s spouse is the beneficiary, then the spouse would qualify as a Designated Beneficiary.

The Treasury Regulations also make clear that only individuals can be Designated Beneficiaries; non-individuals such as charities or the owner/participant’s estate cannot qualify. When multiple beneficiaries are named, if one of them is a non-individual, then the participant will be treated as having no Designated Beneficiary, even if all of the other named beneficiaries are individuals.[3] One exception to this rule is that a trust named as a beneficiary—if it qualifies as a “see-through trust”—will be ignored and the beneficiaries of the trust will be considered when determining the identity of the beneficiaries.[4] Fortunately, in circumstances in which a non-individual that is not a see-through trust is named as a beneficiary, there are two possible strategies that can be employed to enable the individual beneficiaries to be treated as the Designated Beneficiaries nonetheless: (1) separate account treatment; and (2) removing the non-individual beneficiary by the beneficiary finalization date. Both of these options are discussed below. The consequences of failing to have a Designated Beneficiary are also discussed below.

Finally, it is important to note the deadline for determining whether there is a Designated Beneficiary is September 30th of the calendar year following the year of the owner/participant’s death.[5]

Required Beginning Date

The “Required Beginning Date” is April 1st of the year following the year in which the owner/participant is required to first take an RMD.[6] For an IRA, this means that the Required Beginning Date is April 1st of the year following the year in which the owner reaches age 70½.[7] Owners of Roth IRAs are never required to take an RMD, so there is no Required Beginning Date applicable to Roth IRAs.

Determining the Required Beginning Date for a qualified plan participant is more complicated. If the participant is a 5% owner (meaning someone who owns more than 5% of the stock of the sponsoring corporation or who possesses more than 5% of the voting power of the corporation or, if the entity is not a corporation, someone who owns more the 5% of the capital or profits interest) then, the Required Beginning Date is April 1st of the year following the year in which the participant reaches age 70½ (same rule that applies to an IRA owner).[8] If the participant is not a 5% owner, then the Required Beginning Date is April 1st of the year following the later of (i) the year in which the participant reaches age 70½; or (ii) the year of the participant’s retirement.[9] While the plan may offer the “later of” date, it is not required to. The plan may instead mandate that the Required Beginning Date for all participants is April 1st of the year following the year in which the participant reaches age 70½.[10]

Applicable Distribution Period/Five Year Rule/Calculation of RMDs

The “Applicable Distribution Period” refers to the frequency and amounts in which RMDs must be taken from the retirement plan or account. Following an owner/participant’s death, RMDs are based on: (i) the life expectancy of a Designated Beneficiary; (ii) the life expectancy of the owner/participant (although this is rare); or (iii) the “Five Year Rule”.

If the Five Year Rule applies, the plan benefits or account must be paid within five years of the date of the owner/participant’s death.

If an individual life expectancy is the Applicable Distribution Period, the RMD applicable to the beneficiary is calculated by dividing the account balance (as of December 31st of the prior year) by the divisor on the Single Life Table that corresponds to the age the individual (whether the Designated Beneficiary or the owner/participant) attains (or would attain if living) in the current year.[11]

The Treasury Regulations are clear that the Applicable Distribution Period is established, irrevocably, at the time of the owner/participant’s death. However, this is not as absolute as it sounds because, as explained above, the identity of the Designated Beneficiary may be subject to change up until September 30th following the year of the owner/participant’s death.

Multiple Beneficiaries

Often, there are multiple beneficiaries of an owner/participant’s plan benefit or account following the owner/participant’s death. When there are multiple beneficiaries, the general rule is the ADP will be based upon the life expectancy of the oldest beneficiary. This can lead to harsh results for the younger beneficiaries if there is a significant difference between the age of the oldest beneficiary and age of the youngest beneficiary. Fortunately, there are options that can often be used to avoid this result.

One option is to establish separate accounts. If the account or plan benefits are divided into separate accounts (one for each beneficiary) by December 31st of the year following the year of the owner/participant’s death, then each beneficiary is treated as the sole beneficiary of the separate account for his benefit.[12] It is not necessary that the account be physically divided by that deadline, so long as the beneficiaries’ separate shares share, on a pro rata basis, in gains and losses from the date the owner/participant’s death.[13]

Another tool that can be used to avoid unintended outcomes is to remove beneficiaries. As explained above, the deadline for determining whether there is a Designated Beneficiary—and if so, the identity of the Designated Beneficiary—is September 30th of the calendar year following the year of the owner/participant’s death.[14] This leaves some time for certain beneficiaries—particularly those that would jeopardize Designated Beneficiary status—to be removed.[15] A beneficiary can be removed in two ways: (i) by disclaiming his interest; or (ii) by taking a complete distribution of his interest. Importantly, while a beneficiary can be removed by the deadline, it is not possible to create new beneficiaries. For example, if a beneficiary dies before the deadline without disclaiming his interest, he will still be treated as the beneficiary, notwithstanding his death.[16] In addition, if a trust is the beneficiary, and if the trust, by its terms, terminates prior to the deadline, the trust beneficiaries will not be the beneficiaries, rather, the trust will continue to be the beneficiary.[17]

Naming the Beneficiary

With these basic concepts in mind, we can consider each type of beneficiary that an owner/participant may wish to benefit from his retirement plan or account, and the options that will be available to each type of beneficiary.

Surviving Spouse

A surviving spouse who is the Designated Beneficiary has more flexibility in dealing with the retirement plan or account following the owner/participant’s death than any other kind of beneficiary. The Applicable Distribution is favorable as well.

Applicable Distribution Period

If the owner/participant’s surviving spouse is the sole beneficiary of the owner/participant’s plan or account, the Applicable Distribution Period depends on whether the surviving spouse chooses to roll the plan or account into his own IRA, keep the assets in the retirement plan, rolls the plan or account into an inherited IRA, or takes a lump sum distribution. Each of these is discussed below.

Options Available to the Spouse Beneficiary

Spousal Rollover

A surviving spouse who is the Designated Beneficiary has the option of rolling the plan or account into the surviving spouse’s own IRA (whether already in existence or a new account). If the surviving spouse chooses this option, the surviving spouse is then treated as the owner for all purposes. The surviving spouse can name his own beneficiaries, need not take distributions until his required beginning date, and is subject to early withdrawal penalties, if applicable. One of the most significant advantages of choosing a spousal rollover is that the Applicable Distribution Period is determined based on surviving spouse’s life expectancy using the Uniform Life Table, which results in a slower payout than is required under the Single Life Table. In conjunction with that benefit, the surviving spouse’s beneficiaries (who are often the children of the deceased and surviving spouses) may have the opportunity to take distributions based on their own life expectancies if there are assets remaining in the retirement plan or account upon the surviving spouse’s death. One disadvantage of this option is that early withdrawal penalties apply with respect to distributions taken prior to age 59½.

Keep Assets in the Plan

If the retirement assets are in a qualified retirement plan, the plan’s governing instrument may permit the surviving spouse to leave the assets in the plan following the participant’s death. If so, the plan will specify the methods of distribution that are available to the surviving spouse. The method of distribution available must provide for a payout to the surviving spouse that is at least as fast as the manner of distribution that would be available to him under the Treasury Regulations (meaning an Applicable Distribution Period based on the surviving spouse’s life expectancy, as described below). But, the plan can also mandate a faster payout. For example, the plan may require that the entire benefit be paid to the spouse within five years or less, or may require that the benefit be used to purchase an annuity for the surviving spouse. If the payout options available under the plan are not desirable, the surviving spouse should consider rolling the plan benefits into an IRA (either a spousal rollover IRA or an inherited IRA).

Inherited IRA

When a surviving spouse is the Designated Beneficiary, it is often recommended that the surviving spouse roll the account or plan benefit into a spousal rollover IRA. However, there are some situations in which this option will not accomplish the goals of the surviving spouse. For example, if the surviving spouse is younger than age 59½ and wants the ability to take distributions without incurring a 10% early withdrawal penalty, an inherited IRA may be a better option than the spousal rollover IRA.

Practically, this is accomplished by the surviving spouse opening a new IRA as an inherited IRA for the surviving spouse’s benefit (or some similar manner of titling required by the custodian). The surviving spouse then directs the plan administrator or the IRA custodian of the owner/participant to transfer, via a direct trustee to trustee transfer, the assets to the new inherited IRA. If done properly, this is not a taxable event. In addition, the surviving spouse may then choose his own beneficiaries of the account in the event of his death prior to the complete liquidation of the account.

If the surviving spouse chooses this option and if the surviving spouse is the sole Designated Beneficiary, the Applicable Distribution Period is calculated based on the surviving spouse’s life expectancy, using the Single Life Table, recalculated each year.

If the surviving spouse chooses this option and if the surviving spouse is the oldest of multiple Designated Beneficiaries,[18] the Applicable Distribution Period is calculated based on the surviving spouse’s life expectancy, using the Single Life Table; but his life expectancy is not recalculated each year, rather, his life expectancy divisor is reduced by one each year. This method is less favorable because it results in a faster payout of the account than is available under the recalculation method.

Of course, the surviving spouse may take greater or more frequent distributions than is required, if he chooses. No early withdrawal penalty applies.

Lump Sum

Unless the retirement assets are in a qualified retirement plan that prohibits a withdrawal of the plan benefit as a lump sum, the surviving spouse can take the benefit or account as a single lump-sum distribution at any time within five years of the owner/participant’s death. No early withdrawal penalty applies. Keep in mind that the tax impact of this option is often significant. This option is best if the surviving spouse needs funds and cannot afford to take advantage of income tax deferment or if the value of the account or plan benefit is so small that transferring the plan to a new inherited IRA is not cost effective.

Child or Other Non-Spouse as a Beneficiary

Clients often wish to name individuals other than their spouses, such as children and grandchildren, as the primary beneficiaries or contingent beneficiaries. This section explores the considerations that the planner should be thinking about when assisting a client to designate a non-spouse individual as a beneficiary of a retirement plan or account.

Applicable Distribution Period

Assuming the non-spouse beneficiary qualifies as a Designated Beneficiary, the applicable distribution period that applies to the non-spouse beneficiary is the non-spouse beneficiary’s life expectancy unless either: (a) the plan mandates that the Five Year Rule applies;[19] (b) the plan permits the beneficiary to elect the Five Year Rule and the beneficiary makes that election; or (c) the owner/participant died after his required beginning date and the non-spouse beneficiary is older than the owner/participant (in that case, the applicable distribution period is the owner/participant’s remaining life expectancy).

Options Available to the Non-Spouse Beneficiary

Keep assets in the Plan

If the retirement assets are in a qualified retirement plan, the plan’s governing instrument may permit the non-spouse beneficiary to leave the assets in the plan following the participant’s death. If so, the plan will then specify what methods of distribution are available to the non-spouse beneficiary. The plan may allow the non-spouse beneficiary to take distributions over the non-spouse beneficiary’s life expectancy (or the participant’s life expectancy if greater and if the participant had begun taking RMDs prior to his death), or the plan may dictate some other pay-out method so long as the plan benefits are paid at least as quickly as the plan benefits would be paid if using the non-spouse beneficiary’s remaining life expectancy (or the participant’s life expectancy if greater and if the participant had begun taking RMDs prior to his death). For example, the plan may permit the non-spouse beneficiary to take distributions based on the non-spouse beneficiary’s life expectancy (reduced by one each year, as described below). Or, the plan may require that the entire benefit be paid to the non-spouse beneficiary within five years or less of the participant/owner’s date of death.

Inherited IRA

Often, the payout methods available under the qualified plan instrument to a beneficiary of a qualified plan are not ideal. Fortunately, under current law, all plans are required to permit a Designated Beneficiary (regardless of whether the Designated Beneficiary is a surviving spouse or not) to roll the plan benefits into an inherited IRA for the benefit of the Designated Beneficiary.[20] If the retirement assets are held in the deceased owner’s IRA (rather than a qualified plan), this option is also available to the IRA beneficiary. The non-spouse beneficiary opens a new IRA and titles it as an inherited IRA for the benefit of the non-spouse beneficiary (or some similar manner of titling required by the custodian). The non-spouse beneficiary then directs the plan administrator or the IRA custodian to transfer, via a direct trustee to trustee transfer, the assets to the new inherited IRA. If done properly, this is not a taxable event.

If the non-spouse beneficiary chooses this option, the trustee must withdraw the inherited IRA assets at least as fast as required by the Applicable Distribution Period, although the non-spouse beneficiary may take greater or more frequent distributions. No early withdrawal penalty applies.

If the non-spouse beneficiary chooses this option, the Applicable Distribution Period is the non-spouse beneficiary’s life expectancy (unless the owner/participant died after his required beginning date and the non-spouse beneficiary is older than the owner/participant). Each year, beginning December 31st of the year following the owner/participant’s death, the non-spouse beneficiary must take a RMD in an amount equal to the balance of the account or plan benefit as of December 31st of the prior year, divided by the appropriate divisor. [21] The appropriate divisor is the divisor on the IRS’s Single Life Table that corresponds to the age the non-spouse beneficiary attains on his birthday in the year following the year of the owner/participant’s death. Each year thereafter, the divisor is reduced by one—it is not recalculated each year.

Lump Sum

Unless the retirement assets are in a qualified retirement plan that prohibits a withdrawal of the plan benefit as a lump sum (in which case the non-spouse beneficiary can first transfer the benefit to an inherited IRA), the non-spouse beneficiary can take the benefit or account as a single lump-sum distribution at any time within five years of the owner/participant’s death. No early withdrawal penalty applies. Consider the significant tax impact of this option before it is exercised. Again, this option is best if the trust beneficiary needs funds and cannot afford to take advantage of income tax deferment or if the value of the account or plan benefit is so small that transferring the plan to a new inherited IRA is not cost effective.

Estate or Charity as a Beneficiary

If the retirement plan or account is payable to an estate, charity, or other non-individual (other than a see-through trust), the participant or owner is treated as though he has no Designated Beneficiary.[22] Naming the owner/participant’s estate or non-see-through trust as beneficiary of the owner/participant’s retirement plan or account is typically the worst option. Except in rare circumstances or the circumstance described in the following paragraph, there is no benefit—tax or otherwise—to be gained by naming an estate or non-see-through trust as beneficiary.

On the other hand, if an owner/participant is interested in benefitting a charity upon his death, often there is no better asset to leave to a charity than the client’s retirement plan or account. Although a charity is a non-human, which results in the owner/participant having no Designated Beneficiary (and therefore the life-expectancy payout method is unavailable), this distinction is irrelevant because the charity receives no benefit from income tax deferment. Instead, the charity can take a distribution of the entire account or benefit and the untaxed assets in the account or plan will never be subject to income tax.

For example, consider the simple example of a client who is considering leaving $100,000 to charity upon his death, and the client has an IRA valued at $100,000 and $100,000 in cash. If the client leaves the IRA to his children and leaves the cash to the charity, the children will receive, after the payment of income taxes (assuming a 40% marginal rate), approximately $60,000. The charity would receive $100,000. On the other hand, if the client instead named the charity as the beneficiary of his IRA, and left the cash to his children, both his children and the charity would receive $100,000 each.

Applicable Distribution Period

When there is no Designated Beneficiary, the Applicable Distribution Period depends on whether the owner/participant had reached his required beginning date.

i) Owner/Participant Died Prior to Required Beginning Date

If the owner/participant died prior to his required beginning date, the Treasury Regulations provide that the Five Year Rule applies, meaning entire account or plan benefit must be paid to the beneficiary within five years of the date of the owner/participant’s death.[23] While this option is almost always available a beneficiary of an IRA, a beneficiary of a qualified retirement plan may be forced to take distributions even sooner than five years from the date of the participant’s death. This is because qualified retirement plans are permitted to pay out the participant’s death benefit as it chooses so long as the payout occurs within five years of the date of the participant’s death.[24]

Owner/Participant Died After Required Beginning Date

If the owner/participant died after his required beginning date, then the account or plan benefit is to be paid out over the owner/participant’s remaining life expectancy.[25] The owner/participant’s remaining life expectancy is determined by finding the appropriate divisor on the IRS’s Single Life Table. The appropriate divisor is the divisor that corresponds to the age the participant/owner attained or would have attained (if he had lived long enough) on his birthday in the year of his death. Each year after the year of the participant’s death, the divisor is reduced by one (it is not recalculated each year, as would be the case if the participant/owner were still living). Each year, beginning with the year of the owner/participant’s death, the estate or estate beneficiary(ies) must take a distribution in an amount equal to the balance of the account or plan benefit as of December 31st of the prior year, divided by the appropriate divisor. Of course, qualified retirement plans are not required to allow the estate or estate beneficiary(ies) to take distributions in this manner. The plan may dictate some other pay out method so long as the plan benefits are paid at least as quickly as the plan benefits would be paid if using the participant’s remaining life expectancy.

Note that because Roth IRAs have no required beginning date, the Five Year Rule applies, rather than the owner’s remaining life expectancy method.

b) Options Available to the Estate, Charity, or Non-See-Through Trust as a Beneficiary

Keep assets in the Plan

If the retirement assets are in a qualified retirement plan, the plan’s governing instrument may permit the non-individual beneficiary to leave the assets in the plan following the participant’s death. The plan will then dictate what methods of distribution are available to the non-individual beneficiary. The method of distribution available must provide for a payout to the non-individual beneficiary that is at least as fast as the Five Year Rule or the owner/participant’s life expectancy (whichever applies), but the plan can also mandate a faster payout.

Inherited IRA

If the retirement assets are in an IRA, the non-individual beneficiary may roll the plan benefits into an inherited IRA for the benefit of the non-individual beneficiary.[26] The non-individual beneficiary opens a new IRA and titles it as an inherited IRA for the benefit of the estate or charity, as the case may be (or some similar manner of titling required by the custodian). The non-individual beneficiary then directs the plan administrator or the IRA custodian to transfer, via a direct trustee to trustee transfer, the assets to the new inherited IRA. If done properly, this is not a taxable event.

If the non-individual beneficiary chooses this option, the non-individual beneficiary must withdraw the account assets at least as quickly as they would be distributed under the Applicable Distribution Period (the Five Year Rule or the owner/participant’s life expectancy, whichever applies), although the non-individual beneficiary may take greater or more frequent distributions without penalty.

Lump Sum

Unless the retirement assets are in a qualified retirement plan that prohibits such a distribution, the non-individual beneficiary can take the retirement plan benefit or account as a single lump-sum distribution at any time within five years of the owner/participant’s death. No early withdrawal penalty applies.

Trust as a Beneficiary

Typically, planners advise clients to avoid naming trusts (or any other non-individual) as the beneficiary of retirement accounts or plans because the result will be to accelerate the payment of income tax on the entire account or plan benefit in five years of the owner/participant’s death, or sooner. Generally, this is good advice; however, there are some circumstances in which naming individual beneficiaries is just not a good idea, and naming a trust makes more sense when non-tax concerns are considered. For example, a client may want his IRA to benefit his child following his death, but because his child often has financial difficulties, the client does not want the child to have direct access to the IRA. In that case, designating a trust for the child’s benefit is appropriate. A trust is also often preferable when the person the owner/participant wishes to benefit is a minor (or is relatively young or inexperienced), is incapacitated, is a spendthrift, has filed for bankruptcy or has other creditor-related issues, is a person who is married to (or may in the future be married to) someone the owner/participant does not trust or does not want to benefit from the plan or account, or is a second spouse and the owner/participant wants to preserve as much of the IRA or plan benefit as possible for her descendants. When advising a client who is making this calculation, the advisor should consider that, under current law, it usually is possible to stretch RMDs out over the trust beneficiary’s life expectancy even though a non-individual (i.e., a trust) is a beneficiary.

If it is determined that a trust is the appropriate beneficiary, the estate planner should carefully consider how this beneficiary designation will ultimately impact the beneficiary and the trustee. Often, there are some pitfalls that can be avoided by including proper language in the trust agreement or the beneficiary designation itself.

Applicable Distribution Period

As described above, the general rule is that if a non-individual is named as the beneficiary of a retirement plan or account, there is no Designated Beneficiary. There is an exception to this rule that applies to certain trusts that are named as beneficiaries. If a trust qualifies as a “see-through trust”, the trust will be ignored for purposes of identifying the beneficiary and determining the Applicable Distribution Period. If a trust does not qualify as a see-through trust, the rules that apply to an estate as a beneficiary, which are described above, apply to the trust.

See-through trust Requirements

In order for a trust to qualify as a see-through trust, the following five requirements must be satisfied:[27]

▪ Valid under State Law. The trust must be valid under state law (or would be valid but for the fact that there is no corpus). This is requirement is straightforward and will be satisfied in all but the most unusual of cases.

▪ Irrevocable. The trust must be irrevocable or will be irrevocable upon the owner/participant’s death. This requirement is also fairly straightforward. There can be some ambiguity, however, if the trust agreement grants a third party, such as a trust protector, the ability to amend the trust agreement in certain circumstances. So far, there is no IRS guidance on this point. There is another issue to be aware of in community property states such as Arizona, where it is common to create joint trust agreement, of which a portion (usually referred to as the “survivor’s trust”) remains revocable while the surviving spouse is living. The survivor’s trust, generally, should not be named as the beneficiary if see-through trust status is desired.

▪ Identifiable Beneficiaries. The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the owner/participant’s plan or account must be identifiable. The beneficiary or beneficiaries need not be specified by name; so a trust that is for the sole benefit of the owner/participant’s children who survive her would be sufficiently identifiable. If a class of individuals is named as the beneficiaries of the trust, the beneficiaries will be identifiable so long as the identity of the oldest trust beneficiary is identifiable. For example, if a trust is for the benefit of the owner/participant’s issue living from time to time, even though the identity of the beneficiaries could change, the beneficiaries would be considered identifiable because the oldest beneficiary living on the date of the owner/participant’s death would be ascertainable. When drafting a trust that is to be the beneficiary of a retirement plan or account, carefully consider who the beneficiaries are, and whether they are identifiable.

▪ Provide Documentation. The trustee of the trust named as a beneficiary must provide to the plan administrator or IRA custodian, by October 31st of the year after the year of the owner/participant’s death, either a copy of the trust agreement or a list of all of the trust beneficiaries (including contingent beneficiaries) and certify that, to the best of the trustee’s knowledge, the list is correct and complete, and agree to supply a copy of the trust agreement upon demand. It is generally simpler to provide a complete copy of the trust agreement, but for privacy reasons, the list of beneficiaries may be preferable. Also, some plan administrators and IRA custodians require a list in lieu of having to scour the trust agreement themselves to ascertain the beneficiaries. While it is not necessary, it is often a good idea to include a reminder to the trustee in the trust agreement itself that the proper documentation is to be provided to the plan administrator or IRA custodian by the deadline.

▪ Individual Beneficiaries. Finally, all trust beneficiaries must be individuals. This is typically the most problematic requirement. Often a trust benefits multiple beneficiaries. For example, a trust may provide that following the owner/participant’s death, the trustee is to pay, from trust assets, the owner/participant’s final expenses and taxes, make a small gift to charity, and then retain the balance in a trust for the owner/participant’s spouse. In this example, there are multiple potential non-individual beneficiaries: creditors, including the IRS and any state taxing authority, and the charity. Fortunately, the IRS has shown little interest in disqualifying a trust merely because the trustee is instructed to pay the owner/participant’s final expenses and taxes. In the above example, it also would likely be possible to remove the charity as the beneficiary by the beneficiary finalization date by distributing non-retirement plan or account assets to the charity. There are several things that an estate planner can do to facilitate the removal of all non-individual beneficiaries by the beneficiary finalization date, and to reduce the risk of possible complications down the road. First, it is worth including a provision in the trust agreement providing that non-individuals may not benefit from any retirement plan or account naming the trust as the beneficiary.[28] Second, where possible, it is best to identify, in the beneficiary designation form, the appropriate sub-trust that is to be the beneficiary. For example, if an owner/participant’s trust provides that upon the owner/participant’s death, the trustee is to pay the owner/participant’s final expenses, distribute a cash gift to a charity, then the balance of the trust is divided into equal trusts for the owner/participant’s two children, and if the owner/participant wanted these two sub-trusts to be equal beneficiaries of the retirement account or plan, the beneficiary designation should name the two subtrusts directly as co-primary beneficiaries. By doing so, the need pay off the owner/participant’s creditors and the charity by the beneficiary finalization date is eliminated. It also enables each child to use her own life expectancy rather than using the life expectancy of the oldest child for RMDs to both children. Also, if the trust contains powers of appointment, consider including a provision that limits the beneficiary’s ability to exercise his power of appointment in favor of any non-individual or any individual who is older than the primary beneficiary.

If a trust fails any part of this five-part test, then there is no Designated Beneficiary and, as a result, the Applicable Distribution Period is the same distribution period that applies to estates or other non-individual beneficiaries, as described above.

If it is determined that a trust named as a beneficiary of a retirement plan or account is a see-through trust, the trust is ignored and the trust beneficiaries must be considered to determine whether there is a Designated Beneficiary, and if so, who is the Designated Beneficiary.

Multiple Beneficiaries

If the trust designated as the beneficiary of a retirement plan or account has a single beneficiary, the calculation is fairly straightforward. For example, if the sole beneficiary of the trust is a charity, there is no Designated Beneficiary because the sole beneficiary is a non-individual. If the sole beneficiary of the trust is the owner/participant’s child, the child is the Designated Beneficiary.

Typically though, a trust will have more than one beneficiary. Even if a trust is for the benefit of one individual for the remainder of the individual’s life (or until the trust is distributed outright to that person), the trust agreement usually identifies a contingent beneficiary to take trust property in the event the beneficiary dies prior to the complete distribution of the trust. Which beneficiaries are considered and which can be disregarded? Unfortunately, the Treasury Regulations are not clear. But the Treasury Regulations do provide that mere potential successor beneficiaries are to be disregarded. A beneficiary is a mere potential successor beneficiary if he could become the successor to the interest of a beneficiary after the beneficiary’s death. If the potential successor beneficiary has any right (even a contingent right) to the benefit beyond being a mere potential successor, he cannot be disregarded.[29] This is fairly confusing, so here are the general rules:

If the trust provides that all of the retirement plan or account distributions received by the trust are to be passed through to the current beneficiary or beneficiaries (this is often referred to as a “conduit trust”), then the contingent beneficiaries are disregarded.

On the other hand, if the trust provides that any part of the retirement plan or account distributions received by the trust may be accumulated in the trust (sometimes referred to as an “accumulation trust”), the contingent beneficiaries may not be disregarded; rather, both the current beneficiaries and the contingent beneficiaries must be taken into consideration. Therefore, when naming a trust as the beneficiary of a retirement plan or account, estate planners should carefully consider whether a conduit trust or an accumulation trust is appropriate.

When multiple trust beneficiaries must be taken into consideration, the Applicable Distribution Period is determined based upon the life expectancy of the oldest trust beneficiary. Once the identity of that person is determined, calculating the RMD is done as if the trust did not exist.

Separate Account Treatment

One significant disadvantage to naming a trust as the beneficiary of a retirement plan or account is that separate account treatment is not available, even if the trust qualifies as a see-through trust. To illustrate, assume that an IRA owner names his revocable living trust as the beneficiary of his IRA, and his trust provides that upon his death, his trust (which then becomes irrevocable) is divided into equal shares and distributed outright to his four children. While the custodian should comply with a request of the trustee to divide the account into four equal shares, one for each trust beneficiary, and make distributions directly to the four children, the four children will not be able to use their respective life expectancies to measure the RMDs. This is because, by naming the revocable family trust as the beneficiary, separate account treatment is not available.[30] As a result, the four children must use the oldest child’s life expectancy when determining the RMDs. In the planning stage, this can be avoided in two ways: (1) name the four children as the primary beneficiaries on the beneficiary designation form; or (2) if there is a compelling reason for naming the trust (such as if the children are minors), name the four sub-trusts as equal primary beneficiaries on the beneficiary designation form. In either case, separate account treatment should then be available to each child or each child’s trust, meaning each child’s life expectancy can be used for his respective share. It doesn’t hurt to specify on the beneficiary designation form that separate accounts are to be established for the beneficiaries. Note that it is not sufficient to include a provision in the trust agreement directing that separate accounts be established and maintained. This direction must be provided on the beneficiary designation form.

Removing Beneficiaries

As explained above, if there are multiple trust beneficiaries, one or more of whom are not desirable (either because they are a non-individual or because they are older than the other beneficiary or beneficiaries), it may be possible to remove such beneficiaries. This can be done by a beneficiary disclaiming his interest or by making a full distribution to the beneficiary. In either case, the removal must occur by the September 30th deadline.

Marital Deduction Trusts

In some cases, it is desirable to name a qualified trust or other marital deduction trust as the beneficiary of the owner/participant’s retirement plan or account. In this case, it is important to carefully draft the agreement governing the marital deduction trust in a manner that provides for the receipt of retirement assets in a manner that does not jeopardize the marital deduction. For example, the trust agreement should provide that all of the income must be withdrawn from the retirement plan or account and distributed to the surviving spouse at least annually, regardless of the RMD. The trust agreement should also address how income and principal will be determined. It is also a good idea to include in the trust agreement a reminder to the trustee to take a “QTIP” election with respect to the retirement plan or account.

Credit Shelter Trusts

A credit shelter trust can be the beneficiary of a retirement plan or account; however, often the purpose of a credit shelter trust is to preserve trust principal during the surviving spouse’s lifetime for the ultimate benefit of the remainder beneficiaries (often the owner/participant’s children). A retirement plan or account that is payable to a credit shelter trust may be liquidated during the surviving spouse’s lifetime, assuming the surviving spouse is a beneficiary of the credit shelter trust and assuming the surviving spouse lives long enough. As the account is liquidated, a significant portion of the decedent’s benefits or account will be diminished by income taxes. Therefore, while a credit shelter trust can be a beneficiary of a retirement plan or account, it often is not advisable, unless the retirement account is a Roth IRA, which will not be diminished by the payment of taxes..

Options Available to a See-Through Trust as Beneficiary

Keep assets in the Plan

If the retirement assets are in a qualified retirement plan, the plan’s governing instrument may permit the trustee to leave the assets in the plan following the participant’s death. If so, the plan will specify what methods of distribution are available to the trustee. The method or methods of distribution available must provide for a payout to the trust that is at least as fast as the manner of distribution that would be available to it under the Treasury Regulations. As indicated previously, the plan can also mandate a faster payout. For example, if the beneficiary of the see-through trust is the participant’s child, the plan may permit the child to take distributions based on the child’s life expectancy (reduced by one each year, as described above). Or, the plan may require that the entire benefit be paid to the child within five years or less.

Inherited IRA

The trustee may choose to transfer the account or plan benefits to an inherited IRA for the benefit of the trust. The beneficiary opens a new IRA and titles it as an inherited IRA for the benefit of the trust (or some similar manner of titling required by the custodian). The trustee of the trust then directs the plan administrator or the IRA custodian of the owner/participant to transfer, via a direct trustee to trustee transfer, the assets to the new inherited IRA. If done properly, this is not a taxable event.

If the trustee chooses this option, the trustee must withdraw the account assets at least as fast as required by the Applicable Distribution Period (which is determined by looking through the trust to the trust beneficiary), although the trustee may take greater or more frequent distributions.

Lump Sum

Unless the retirement assets are in a qualified retirement plan that prohibits a withdrawal of the plan benefit as a lump sum, the trustee can take the benefit or account as a single lump-sum distribution. Keep in mind that the tax impact of this option is often significant. This option is best if the trust beneficiary needs funds and cannot afford to take advantage of income tax deferment or if the value of the account or plan benefit is so small that transferring the plan to a new inherited IRA is not cost effective.

Other Points to Consider

Consider Exhibits

It may not be possible for the client or estate planner to provide adequate instructions to the plan administrator or IRA custodian on the beneficiary designation form provided. If this is the case, attach an exhibit to the beneficiary designation form, which contains more lengthy instructions.

Consider the Limitations of the Administrator/Custodian

When providing instructions to the custodian or plan administrator, consider whether the custodian or administrator will honor the request. In many cases, they will not. For example, it is tempting to include a provision in the beneficiary designation prohibiting a beneficiary from taking withdrawals in excess of the RMD until the beneficiary reaches a certain age. Many custodians or administrators will not honor this request, so an alternative plan (such as making the benefits or account payable to a custodial account or trust) should be considered.

Provide the information requested

Beneficiary designation forms usually request information about the beneficiaries in addition to their names. One form may request birthdates and social security numbers. Another form may request addresses, phone numbers, and the beneficiary’s relationship to the owner/participant. When a separate exhibit is used, take care to include on the exhibit the information that is requested on the form.

Ask for approval while the client is living

It is recommended that the beneficiary designation form (and exhibit, if any) be forwarded to the custodian or administer for the review and approval of the custodian or administrator. Obviously, if the custodian or administrator has any problems with the beneficiary designation, it is best to address these problems while the beneficiary is living.

Do name contingent beneficiaries

Some owner/participants will tell their advisors that they have completed a beneficiary designation form for their retirement plan or account, but without further inquiry will not disclose that only a primary beneficiary is designated. Unless the primary beneficiary is a non-individual (such as a charity or a trust), it is good idea to name a contingent beneficiary. This will lessen the possibility that the owner/participant’s estate winds up as the beneficiary of the owner/participant’s account or retirement plan, which could occur if the primary beneficiary predeceases the owner/beneficiary.

Death of the Designated Beneficiary

Because the Applicable Distribution Period is established at the time of the owner/participant’s death, the subsequent death of the beneficiary or termination of the trust (if the trust is a beneficiary) does not alter the Applicable Distribution Period. Instead, the successor beneficiary to the Designated Beneficiary will continue to take distributions based on the Applicable Distribution Period as if the Designated Beneficiary were will alive (or in existence, in the case of a trust).

Learn the Lingo

Each plan administrator and IRA custodian has its own terminology and set of forms. Prior to giving the custodian or administrator instructions, it is a good idea to learn this terminology and obtain the proper forms. For example, if a beneficiary elects to transfer the account or plan benefits to an inherited IRA, the IRA custodian will typically require the beneficiary to open a new inherited IRA for the beneficiary, into which the assets of the owner’s account are to be transferred. Some custodians will instead re-title the owner’s account. Therefore, prior to instructing the custodian, determine what is the practice of the custodian and what terminology the custodian uses. This will save time and avoid miscommunication. Avoiding miscommunication is particularly important when instructing the custodian to transfer the deceased owner’s assets because if the deceased owner’s assets are inadvertently transferred out of the deceased owner’s IRA, they cannot be returned.

Practical Considerations Often Trump Tax Considerations

If an intended beneficiary is minor, incapacitated, or a spendthrift, it is unlikely that the client will want to leave any portion of the retirement plan or account to that beneficiary free of trust. Consider whether naming a custodial account or trust as the beneficiary is appropriate in these circumstances, rather than naming the individual as the beneficiary. A trusteed IRA may also be a good solution.

|Single Life Table |

|Age |

Age |Life Expectancy | |Age |Life Expectancy | | | | | | | |84 |8.1 | |105 |1.9 | | | | | | | |85 |7.6 | |106 |1.7 | | | | | | | |86 |7.1 | |107 |1.5 | | | | | | | |87 |6.7 | |108 |1.4 | | | | | | | |88 |6.3 | |109 |1.2 | | | | | | | |89 |5.9 | |110 |1.1 | | | | | | | |90 |5.5 | |111+ |1.0 | | | | | | | |91 |5.2 | | | | | | | | | | |92 |4.9 | | | | | | | | | | |93 |4.6 | | | | | | | | | | |94 |4.3 | | | | | | | | | | |95 |4.1 | | | | | | | | | | |96 |3.8 | | | | | | | | | | |97 |3.6 | | | | | | | | | | |98 |3.4 | | | | | | | | | | |99 |3.1 | | | | | | | | | | |100 |2.9 | | | | | | | | | | |101 |2.7 | | | | | | | | | | |102 |2.5 | | | | | | | | | | |103 |2.3 | | | | | | | | | | |104 |2.1 | | | | | | | | | | |

Suggested Trust Language

This language will not be appropriate in all cases. Carefully consider which provisions should be used and how each should be modified to address each situation. A definition for Retirement Account and Retirement Interest will n

Section 1. Retirement Interests. This Section applies with respect to any Retirement Interest and supersedes the other provisions of this Trust Agreement to the extent that such other provisions are inconsistent with this Section. “Retirement Account” means a plan, fund, account, annuity, or other arrangement, the distributions from which are required to comply with Section 401(a)(9) of the Internal Revenue Code or other comparable provisions of law, and an interest of which is held as a part of, or distributable to, a trust under this Trust Agreement. “Retirement Interest” means an interest in any Retirement Account.

Withdrawal of Required Minimum Distributions. Each year, beginning with the year of the owner/participant’s death, the Trustee shall withdraw from any Retirement Account the amount required to be withdrawn for the corresponding Retirement Interest for that year, pursuant to the required minimum distribution rules under Internal Revenue Code Section 401(a)(9).

Marital Trust. Notwithstanding any contrary provision in this Trust Agreement, with respect to a Retirement Interest that is payable to the Marital Trust/QTIP Trust [DEFINE], each year the Trustee shall withdraw from the Retirement Account and distribute outright to the surviving settlor the greater of: (1) the net income of the marital trust’s share of the Retirement Account for that year; and (2) the required minimum distribution with respect to the marital trust’s share of the Retirement Account.

Additional Withdrawals. From time to time, the Trustee may withdraw from any Retirement Account an amount in excess of the required minimum distribution under paragraph (a) or (b) above, to satisfy a distribution (discretionary or otherwise) provided for elsewhere in this Trust Agreement, but only to the extent that it would be impractical to make that distribution with non-Retirement Account assets.

(d) Distribution to Beneficiaries. [OPTION #1: CONDUIT TRUST –Upon receipt by the Trustee (and in no event less frequently than annually), and notwithstanding any provision to the contrary in this Trust Agreement, the Trustee shall distribute all amounts withdrawn from a Retirement Interest outright to, and only to, the current beneficiary of the trust holding such Retirement Interest.] OR [OPTION #2 ACCUMULATION TRUST— Upon receipt of a withdrawal from a Retirement Account, the Trustee shall distribute some or all of the amount so withdrawn outright to, and only to, the then current beneficiary of the trust holding such Retirement Interest, but only to the extent that such distribution is provided for elsewhere in this Trust Agreement. To the extent such distribution is not provided for elsewhere in this Trust Agreement, the income and principal attributable to such withdrawal (at least annually) will be accumulated and added to the principal of the trust.

(e) Non-Designated Beneficiary Treatment. A Retirement Interest and distributions or benefits therefrom, will not be used in any manner that would cause the corresponding Retirement Account to be treated as not having a designated beneficiary (“Non-Designated Beneficiary Treatment”). Such use includes (but is not limited to) the following to the extent that it would cause Non-Designated Beneficiary Treatment: (A) payment of any legal obligations of a deceased beneficiary’s estate, including (without limitation) probate administration expenses, debts, death taxes, and funeral or memorial expenses; (B) satisfaction of any pecuniary distribution, gift, or bequest; and (C) payment to any entity, organization, or other non-individual. By way of example, upon the death of a settlor, the Trustee could not, on or after September 30th of the calendar year following the calendar year in such settlor’s death occurs (the “Beneficiary Finalization Date”), make any distribution from a Retirement Account to or for the benefit of that settlor’s estate, any charity, or any other non-individual beneficiary.

(f) No Contingent Beneficiary Older than Primary Beneficiary. No distribution of a Retirement Interest may be made on or after the Beneficiary Finalization Date to any contingent beneficiary (as that term is defined in the applicable Treasury Regulations) who [OPTION 1: is an individual older than the oldest primary beneficiary (as that term is defined in the applicable Treasury Regulations) OR OPTION 2: is an individual born prior to ____________]. However, the Trustee will have the power to distribute to such older individual, prior to the Beneficiary Finalization Date, all Retirement Accounts and/or interests to which such individual is entitled without reference to this paragraph. If, by reason of the first sentence of this paragraph, distribution of a Retirement Account would otherwise fail for want of a beneficiary, the Trustee will then have the limited power to select one or more individuals (other than the Trustee, the Trustee’s estate, the Trustee’s creditors, and the creditors of the Trustee’s estate), who are not [OPTION 1: older than the oldest primary beneficiary OR OPTION 2: born prior to ___________], to receive such distribution in the proportions and manner determined by the Trustee in the Trustee’s sole discretion. It is the settlors’ precatory wish that the Trustee exercise such power, if at all, in a manner that the Trustee reasonably believes would be consistent with the settlors’ desires.

(g) Administrative Matters. For any Retirement Interest, the Trustee shall timely deliver to the plan administrator, trustee, custodian, or issuer (as applicable) of the any Retirement Account any documents and/or certifications required by the Treasury Regulations in order for the applicable trust beneficiary(ies) to be treated as the “designated beneficiary(ies)” of such Retirement Account (assuming all other requirements are met). Such documents may include (but are not necessarily limited to) a copy of this Trust Agreement, including all amendments hereto (if any), as may be required.

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[1] Treas. Reg. § 1.401(a)(9)-4, A-1; Although the definition describes a qualified plan, it applies to an IRA as well.

[2] Treas. Reg. § 1.401(a)(9)-4, A-2

[3] Treas. Reg. § 1.401(a)(9)-4, A-3

[4] Treas. Reg. § 1.401(a)(9)-4, A-5

[5] Treas. Reg. § 1.401(a)(9)-4, A-4

[6] Treas. Reg. § 1.401(a)(9)-5, A-1(c)

[7] I.R.C. §. 408(a)(6); 401(a)(9)(C)(i)(I), (ii)(II)

[8] Treas. Reg. § 1.401(a)(9)-2, A-2(c)

[9] Treas. Reg. § 1.401(a)(9)-2, A-2(a)

[10] Treas. Reg. § 1.401(a)(9)-2, A-2(e)

[11] Treas. Reg. § 1.401(a)(9)-5, A-4(a), (b), A-5(c)

[12] Treas. Reg. § 1.401(a)(9)-8, A-2(a)(2)

[13] Treas. Reg. § 1.401(a)(9)-8, A-3

[14] Treas. Reg. § 1.401(a)(9)-4, A-4

[15] See Treas. Reg. § 1.401(a)(9)-4, A-4(a)

[16] Treas. Reg. § 1.401(a)(9)-4, A-4(c)

[17] This does not mean that the trust must continue in existence, it is possible, if the IRA custodian is cooperative, to make the IRA payable to the trust beneficiaries following the trusts’ termination. However, the applicable distribution period would continue to apply as if the trust were in existence.

[18] Because of the ability to create separate accounts, typically a surviving spouse will be one of several beneficiaries only in the event a trust for multiple beneficiaries, including the surviving spouse, is the beneficiary.

[19] Treas. Reg. § 1.401(a)(9)-3, A-4(b)

[20] I.R.C. § 402(c)(11). Note that a plan participant could eliminate the availability of this option if the plan allows the participant to elect that distributions made to his beneficiary be made in a substantially equal series of payments, and the participant makes this election (typically, this would be done on a beneficiary designation form).

[21] Treas. Reg. § 1.401(a)(9)-2, A-5; 1.104(a)(9)-3, A-3(a)

[22] Treas. Reg. § 1.401(a)(9)-4, A-3

[23] Treas. Reg. § 1.401(a)(9)-3, A-4(a)(2)

[24] Treas. Reg. §. 1.401(a)(9)-3, A-4(b)

[25] Treas. Reg. §. 1.401(a)(9)-5, A-5(a)(2)

[26] I.R.C. § 402(c)(11)

[27] Treas. Reg. § 1.401(a)(9)-4, A-5

[28] See PLR 2004-10020

[29] Treas. Reg. § 1.401(a)(9)-5, A-7(c)

[30] See Treas. Reg. § 1.401(a)(9)-4, A-5(c)

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